Finance and incentives for net zero transition – Why EMDEs need carbon pricing
THERE needs to be a massive reallocation of economic resource towards financing net zero investments but it is not happening fast enough, especially in emerging markets and developing economies (EMDEs).
The financing paradox
We start with some money figures. Infrastructure sectors in EMDEs raised more than US$500 billion in loans and bonds in 2021. That’s from the financing side. In EMDEs, total investments in fossil fuel-based infrastructure (from oil and gas to conventional power generation) amounted to US$210 billion in 2021 and US$1.24 trillion since 2015. These are based on open-source data in the marketplace, and do not include spending obscured by non-market fiscal subventions or subsidies towards fossil fuel sectors (which are substantial). Conversely, total investment in renewable energy sources amounted to US$45 billion in 2021 only, and US$235 billion since 2015.
Furthermore, there is also a prevailing stance in many EMDEs that the state-owned companies continue to invest and hold fossil fuel-related infrastructure as critical national assets, while renewables like solar or wind power development are carried out by the private sector through public–private partnerships (PPPs). The financing advantage the state typically enjoys is thus not fully channelled towards renewables.
Hence, on the one hand, many policymakers highlight the large financing gaps for net zero transition. On the other hand, we see the large financing capacity of EMDE firms (including many state-owned enterprises) and the channelling of investments into fossil fuel sectors. It is as much a financing gap as it is a financing trap. This paradox can only be understood in the context of insufficient reallocation of economic resources towards net zero.
The double externalities
There are two related issues with the same root cause. First, the continued lack of carbon price to drive reallocation of economic activities. Carbon pricing fixes several externalities at one go. It reduces waste of existing energy use by businesses and households and encourages them towards use of cleaner energy. Carbon pricing also creates pressures for the most pollutive firms in each industry to change or to exit, ceding market shares to the more productive ones. These important reallocation dynamics do not work well otherwise.
Second, and perhaps less articulated, is how the lack of carbon price hampers the innovation processes towards net zero. It is well known that firms underinvest in innovation because they often do not capture the full economic benefits of their innovation. Studies have confirmed that one innovation often leads to spillovers to benefit other innovators, in other geographies and sectors.
To put things in an even starker perspective, fossil fuel companies are not standing still, they too are innovating to produce at lower costs. One only has to recall that fracking technology in the past two decades has added large supplies of gas to the market. Today, the high energy prices mean that there are strong incentives, even if unspoken, to innovate and produce more. To be fair, fossil fuel companies have also innovated in areas towards cleaner production of fossil fuels (eg reducing methane flaring and saving energy used in production). But this is at best an interim stage towards net zero. Better production of fossil fuels would still lead to climate damage.
Clearly, a lot of new technologies like battery and storage, green hydrogen, carbon capture would have to be technically and commercially viable to make a net zero economy possible. Innovations that that help solve the intermittency problem for renewables will also reduce policymakers’ concerns around energy security. Incentives towards innovation and adoption of green technology need to be sharpened.
The unpriced nature of greenhouse emissions thus creates not one but a double negative reinforcing externalities – one at the production and consumption end, and the other at the innovation end. Incentives towards net zero remain underpowered in EMDEs as a result.
Risk of losing competitiveness
There is another hidden long-term risk for EMDEs in falling behind in the net zero transition – the loss of competitiveness and innovation capacity in important green sectors. Many advanced economies have implemented a carbon price or stringent regulations. This has compelled companies to innovate and adapt more quickly towards net zero. The majority of net zero related patents (eg renewables and waste management) are still filed by companies in major advanced economies, in terms of both volume and patent market value. The incentives and pressures are arguably less in EMDEs.
Yet within a few short decades, all production and international trade will have to be consistent with net zero. Green infrastructure and production will become the basis of international competitiveness. Falling behind in critical innovations and business processes would mean having to import these technologies or goods later, or risk begin priced or regulated out of the global marketplace. Hence, getting an early momentum in net zero transition is important to allow for the accumulation of knowledge and know how.
A roadmap for a low carbon economy
Imposing a carbon price with the backdrop of high inflation will not be easy. One might even argue that a high energy price arising from the war in Ukraine already acts like a carbon price. Except that it is not equivalent. While a high price will curtail fossil fuel demand, we must again realise that this reallocates resources into fossil fuel sectors – opposite of what a carbon price seeks to achieve. It leaves windfall profits at the hands of fossil fuel companies rather than as taxes for the state. A high fossil fuel price is a poor substitute for an actual carbon price.
A carbon price can be implemented in stages. One way is to first impose a shadow carbon price on all state-owned companies, essentially requiring them to plan and invest as if a carbon price is already there. It can also start with large polluters first. There should be also a plan to exit select industries that no longer fit the context of a low carbon economy.
Imposing annual limits on banking or bond financing that can flow into fossil fuel sectors would bring about a shadow carbon price through finance, allowing constraints to kick in without hitting headline inflation at one go. Of course, over time, a transparent carbon price should be set for the price signal to guide the needed reallocation rather than ad hoc administrative policies.
Many EMDEs have in the past encouraged FDIs into key sectors to jumpstart economic development, participate in global value chains, and benefit from knowledge diffusion. This can be a key part of the strategy towards a low carbon economy. Again, starting early will avoid large capacity gaps from developing later and with it, the loss of competitiveness. EMDEs will need to act fast.
The writers are from the Asian Infrastructure Investment Bank. Dr Thia Jang Ping is lead economist and manager of the economics department; Gao Jingyu is associate economist.
